Chapter 9

Benefit/Cost
Analysis
Lecture slides to accompany

Engineering Economy
8th edition

Leland Blank
Anthony Tarquin

9-1
 LEARNING OUTCOMES

1. Explain difference in public vs. private sector projects

2. Calculate B/C ratio for single project
3. Select better of two alternatives using B/C method
4. Select best of multiple alternatives using B/C method
5. Use cost-effectiveness analysis (CEA) to evaluate
service sector projects

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 Public Sector Projects
 Public sector projects are owned, used and financed by the
citizenry of any government level.
 Public sector projects have a primary purpose to provide
services for the public good at no profit.
 Samples of public sector projects often deal with health,
safety, utilities and public welfare and include: hospitals,
sewers, police and fire protection and bridges.

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 Differences: Public vs. Private Projects
Characteristic Public Private
Size of Investment Large Small, medium, large

Life Longer (30 – 50+ years) Shorter (2 – 25 years)

Annual CF No profit Profit-driven

To perform an economic analysis of public alternatives, the costs, the benefits

and the disbenefits must be estimated as accurately as possible in monetary
units.
• Costs. Estimated expenditures for construction, operation and
maintenance of the project less salvage value.
• Benefits. Advantages to the owners, the public
• Disbenefits. Expected undesirable or negative consequences to the
owners if the alternative is implemented

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 Differences: Public vs. Private Projects
Characteristic Public Private
Funding Taxes, fees, bonds, etc. Stocks, bonds, loans, etc.

Interest rate Lower Higher

from 4-8%. i is usually referred to as the discount rate.
Selection criteria Multiple criteria Primarily ROR
Multiple categories of users, economic as well as noneconomic interests, and
special-interest political and citizen groups make the selection of one
alternative over another much more difficult in public sector economics.
Environment of evaluation Politically inclined Economic
The viewpoint of the public sector analysis must be determined before cost,
benefit and disbenefit estimates are made and before the evaluation is
formulated and performed. Perspectives include: the citizen; tax base; jobs;
economic development; a particular interest such as agriculture.
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 Cash Flow Classifications
Must identify each cash flow as either benefit, disbenefit, or cost

Benefit (B) -- Advantages to the public

Disbenefit (D) -- Disadvantages to the public
Cost (C) -- Expenditures by the government
Note: Savings and salvage values to government are subtracted from costs

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 B/C Relations
Conventional B/C ratio = (B–D) / C
Modified B/C ratio = [(B–D) – M&O] / Initial Investment
Profitability Index = NCF / Initial Investment

Note 1: All terms must be expressed in same units, i.e., PW, AW, or FW
Note 2: Do not use minus sign ahead of costs
Note 3: Salvage values are subtracted from costs in the denominator.
Note 4: When used solely for a private sector project, the disbenefits are usually
omitted, the computations for PI and modified B/C are essentially the same,
except the PI is usually applied without disbenefits estimated.

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 Decision Guidelines for B/C and PI
Benefit/cost analysis
If B/C ≥ 1.0, project is economically justified at
discount rate applied
If B/C < 1.0, project is not economically acceptable
Note: The two B/C methods will just differ in the magnitude of the ratio but will
yield the same decision (accept or reject) Example 9.2, Page 236.
Profitability index analysis of
revenue projects
If PI ≥ 1.0, project is economically justified at
discount rate applied
If PI < 1.0, project is not economically acceptable
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 B/C Analysis – Single Project
B-D
Conventional B/C ratio = If B/C ≥ 1.0,
C
B – D – M&O accept project;
Modified B/C ratio =
initial investment Otherwise, reject

Denominator is
PW of NCFt
PI = initial investment
PW of initial investment

If PI ≥ 1.0,
accept project;
otherwise, reject
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 Example: B/C Analysis – Single Project

A flood control project will have a first cost of $1.4 million with an annual
maintenance cost of $40,000 and a 10 year life. Reduced flood damage is
expected to amount to $175,000 per year. Lost income to farmers is estimated
to be $25,000 per year. At an interest rate of 6% per year, should the
project be undertaken?

Solution: Express all values in AW terms and find B/C ratio

B = $175,000
D = $25,000
C = 1,400,000(A/P,6%,10) + $40,000 = $230,218
B/C = (175,000 – 25,000)/230,218
= 0.65 < 1.0
Do not build project
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Example: B/C Analysis – Single Project

Example 9.3 Page 247

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Defender, Challenger and Do Nothing Alternatives

When selecting from two or more ME alternatives, there is a:

 Defender – in-place system or currently selected alternative
 Challenger – Alternative challenging the defender
 Do-nothing option – Status quo system

General approach for incremental B/C analysis of two ME alternatives:

 Lower total cost alternative is first compared to Do-nothing (DN)
 If B/C for the lower cost alternative is < 1.0, the DN option is compared to
∆B/C of the higher-cost alternative
 If both alternatives lose out to DN option, DN prevails, unless overriding
needs requires selection of one of the alternatives

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Alternative Selection Using Incremental B/C
Analysis – Two or More ME Alternatives

Procedure similar to ROR analysis for multiple alternatives

(1) Determine equivalent total cost for each alternative

(2) Order alternatives by increasing total cost
(3) Identify B and D for each alternative, if given, or go to step 5
(4) Calculate B/C for each alternative and eliminate all with B/C < 1.0
(5) Determine incremental costs and benefits for first two alternatives
(6) Calculate ∆B/C; if >1.0, higher cost alternative becomes defender
(7) Repeat steps 5 and 6 until only one alternative remains

© 2012 by McGraw-Hill All Rights Reserved

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 Example: Incremental B/C Analysis
Compare two alternatives using i = 10% and B/C ratio
Alternative X Y
First cost, $ 320,000 540,000
M&O costs, $/year 45,000 35,000
Benefits, $/year 110,000 150,000
Disbenefits, $/year 20,000 45,000
Life, years 10 20

Solution: First, calculate equivalent total cost

AW of costsX = 320,000(A/P,10%,10) + 45,000 = $97,080
AW of costsY = 540,000(A/P,10%,20) + 35,000 = $98,428
Order of analysis is X, then Y
X vs. DN: (B-D)/C = (110,000 – 20,000) / 97,080 = 0.93 Eliminate X
Y vs. DN: (150,000 – 45,000) / 98,428 = 1.07 Eliminate DN

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Example: ∆B/C Analysis; Selection Required
Must select one of two alternatives using i = 10% and ∆B/C ratio
Alternative X Y
First cost, $ 320,000 540,000
M&O costs, $/year 45,000 35,000
Benefits, $/year 110,000 150,000
Disbenefits, $/year 20,000 45,000
Life, years 10 20
Solution: Must select X or Y; DN not an option, compare Y to X
AW of costsX = $97,080 AW of costsY = $98,428
Incremental values: ∆B = 150,000 – 110,000 = $40,000
∆D = 45,000 – 20,000 = $25,000
∆C = 98,428 – 97,080 = $1,348
Y vs. X: (∆B - ∆D) / ∆C = (40,000 – 25,000) / 1,348 = 11.1 Eliminate X

9-15 © 2012 by McGraw-Hill All Rights Reserved

 B/C Analysis of Independent Projects

 Independent projects comparison does not require

incremental analysis
 Compare each alternative’s overall B/C with DN option

+ No budget limit: Accept all alternatives with B/C ≥ 1.0

+ Budget limit specified: capital budgeting problem; selection
follows different procedure (discussed in chapter 12)

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 Cost Effectiveness Analysis
Service sector projects primarily involve intangibles, not
physical facilities; examples include health care, security
programs, credit card services, etc.

Cost-effectiveness analysis (CEA) combines monetary cost

estimates with non-monetary benefit estimates to calculate the
Cost-effectiveness ratio (CER)

Equivalent total costs

CER = Total effectiveness measure
= C/E
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 CER Analysis for Independent Projects
Procedure is as follows:
(1) Determine equivalent total cost C, total effectiveness measure E and CER
(2) Order projects by smallest to largest CER
(3) Determine cumulative cost of projects and compare to budget limit b
(4) Fund all projects such that b is not exceeded

Example: The effectiveness measure E is the number of graduates from adult

training programs. For the CERs shown, determine which independent
programs should be selected; b = $500,000.

Program CER, $/graduate Program Cost, $

A 1203 305,000
B 752 98,000
C 2010 126,000
D 1830 365,000
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Example: CER for Independent Projects
First, rank programs according to increasing CER:
Cumulative
Program CER, $/graduate Program Cost, $ Cost, $

B 752 98,000 98,000

A 1203 305,000 403,000
D 1830 365,000 768,000
C 2010 126,000 894,000

Next, select programs until budget is not exceeded

Select programs B and A at total cost of $403,000
Note: To expend the entire $500,000, accept as many additional
individuals as possible from D at the per-student rate
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CER Analysis for Mutually Exclusive Projects

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Example: CER for ME Service Projects
The effectiveness measure E is wins per person. From the cost
and effectiveness values shown, determine which alternative to
select.

Cost (C) Effectiveness (E) CER

Program $/person wins/person $/win
A 2200 4 550
B 1400 2 700
C 6860 7 980

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 Example: CER for ME Service Projects
Solution:
Order programs according to increasing effectiveness measure E

Cost (C) Effectiveness (E) CER

Program $/person wins/person $/win

B 1,400 2 700
A 2,200 4 550
C 6,860 7 980
B vs. DN: C/EB = 1400/2 = 700
A vs. B: ∆C/E = (2200 – 1400)/(4 – 2) = 400 Dominance; eliminate B
C vs. A: ∆C/E = (6860 – 2200)/(7 – 4) = 1553 No dominance; retain C

Must use other criteria to select either A or C

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Summary of Important Points
B/C method used in public sector project evaluation

Can use PW, AW, or FW for incremental B/C analysis, but must
be consistent with units for B,C, and D estimates
For multiple mutually exclusive alternatives, compare two at a time
and eliminate alternatives until only one remains

For independent alternatives with no budget limit, compare each against

DN and select all alternatives that have B/C ≥ 1.0

CEA analysis for service sector projects combines cost and

nonmonetary measures

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